Fitch upgrades BAE Systems’ ratings, citing strong cash flow and profitability

Investing.com -- On Thursday, Fitch Ratings upgraded the Long-Term Issuer Default Rating (IDR) and senior unsecured debt ratings of BAE Systems (LON:BAES) plc (BAE) to ’A-’ from ’BBB+’, while maintaining a stable outlook. The Short-term IDR has been affirmed at ’F1’.

The ratings upgrade comes on the back of Fitch’s expectation that BAE’s profitability and free cash flow (FCF) generation will likely see a boost from its record order backlog and an improving business profile. Fitch anticipates that these improvements will be sustainable, aligning key ratios with an ’A-’ rating. The agency also expects BAE’s stable financial policy and solid capital structure to continue supporting the improvement in profitability and cash flow.

BAE’s rating further reflects its leading position in the global defense sector, robust revenue visibility, and strong geographical and product diversification. The company’s critical contribution to key international defense programs also plays a significant role in mitigating sector risks.

Fitch predicts BAE’s FCF margins to be strong, at a minimum of 4% in 2025 and 2026, before rising above 5% on a sustainable basis. This level is consistent with the ’A’ rating category for the aerospace and defense sector. The strength of the FCF margins is supported by BAE’s rising underlying profitability, stable working capital flows, strong absorption capability of capex, and a moderate dividend policy.

BAE’s EBITDA margin is expected to gradually rise to 14% over the medium term, driven by effective management of its record order backlog and improved operational efficiencies. This growth will be supported by robust expansion in the electronic systems division profitability, along with more modest growth in the cyber and intelligence and maritime divisions.

BAE maintains a robust capital structure with excellent liquidity and a long-term debt maturity profile. Fitch expects EBITDA gross and net leverage to reach around 2x and 1.5x, respectively, at year-end 2025 on stronger EBITDA generation and the repayment of its 2025 bond maturity.

BAE’s record order backlog, which rose to GBP 78 billion at the end of 2024, from GBP 70 billion at the end of 2023, supports robust revenue visibility over the medium-to-long term. The company’s healthy diversification and mission-critical position in long-term defense programs in key markets like the US, the UK, EU, Saudi Arabia, and Australia, as well as its joint ventures, allow it to benefit from the overall strong growth in defense spending globally.

Fitch expects BAE to continue maintaining a strong balance sheet, while adhering to its longstanding shareholder return and investment strategy. This strategy involves organic growth through R&D investments, acquisitions, and shareholder returns through dividends and share buybacks.

In terms of peer analysis, BAE has better geographic diversification than most of its US peers, such as Lockheed Martin Corporation (NYSE:LMT) (A/Stable) and Northrop Grumman Corporation (NYSE:NOC) (BBB+/Stable). BAE’s EBITDA leverage is forecasted to be modestly better than that of most peers, while converging with Lockheed Martin’s over the medium term.

Fitch’s key assumptions include revenue growth averaging 8% to 2028, EBITDA margin consistently between 12.5%-14% until 2028, stable annual capex at 4% of revenue until 2028, and a gradual increase in dividend payments, in line with profitability.

Potential factors that could lead to a negative rating action or downgrade include EBITDA leverage and EBITDA net leverage sustained above 2.5x and 2x, respectively, reduced revenue visibility with the backlog to revenue ratio sustained under 2.0x, and FCF margin sustained below 5%. Conversely, factors that could lead to a positive rating action or upgrade include EBITDA leverage and EBITDA net leverage sustained below 2x and 1.5x, respectively, EBITDA margin sustained above 15%, and FCF margin sustained above 6%.

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